Cost Benefit Analysis (CBA), sometimes also referred to as Benefit-Cost Analysis (BCA), is a harmonised set of tools addressing economic and public decision-making. It is used in assessing whether a proposed project or programme is worth doing, whether it is worth funding and to what extent it is worth funding, and to choose between several alternative projects or programmes, or different versions of the same project or programme. Evaluation involves a comparison of the expected financial costs and revenues of each option and a set of predefined financial Key Performance Indicators (KPIs) like the Internal Rate of Return (IRR) and Net Present Value (NPV), as well as their economic counterparts, these being the Economic Internal Rate of Return (EIRR), the Economic Net Present Value (ENPV) and the cost-benefit ratio. The latter set of KPIs involves some form of conversion which can be undertaken through shadow pricing or through monetisation on the basis of the elicitation of WTP or the transfer of benefits from a similar study.
The history of the theoretical origins of Cost Benefit Analysis go back to nineteenth century infrastructure investment appraisal in France, where welfare economics theory developed pari passu with the nineteenth century microeconomic “marginalist” revolution, and which culminated in Pigou’s 1920 magnum opus titled “Economics of Welfare”. Here, the notion of the divergence of private and social cost was formalised, and ordinal utility welfare economics was born. Divergences, however, remained between theory and practice until a formal requirement for costs and benefits to be compared emerged in US water-related investment appraisals in the late 1930’s.Essentially, Cost Benefit Analysis is based on the theory that welfare effects should be measured using benefits, tantamount to increases in human wellbeing (utility) and costs, with the latter representing reductions in human wellbeing (disutility). From a public sector perspective, a project or policy can only qualify on cost-benefit grounds if its social benefits exceed its social costs. From a private sector perspective, on the other hand, the criterion to be met is for financial revenues to exceed financial costs. The theoretical foundations for Cost Benefit Analysis can be briefly summarised as follows: a) The preferences of individuals are to be taken as the source of value. To say that an individuals’ well-being, welfare or utility is higher in state A than in state B is to say that s/he prefers A to B; b) Preferences are measured by a Willingness To Pay (WTP) for a benefit and a Willingness To Accept compensation (WTA compensation) for a cost;
c) It is assumed that individuals’ preferences can be aggregated so that social benefit is simply the sum of all individuals’ benefits and social cost is the sum of all individuals’ costs where some degree of cardinalisation of utility is essentially assumed;
d) If beneficiaries from a change can hypothetically compensate the losers from a change in a Coasean style bargain, and have some net gains left over, then the basic test that social benefits exceed social costs is met.
Following the Second World War, pressures for “efficiency in government” and the resulting endeavour for ascertaining the efficient utilisation of public funds in major public investments occasioned the fusion of welfare economics (essentially Cost Benefit Analysis) and decision-making. Since the 1960s the Cost Benefit Analysis method has had its ups and downs, but has today come to be recognised as the major appraisal technique for public investments and public policy.
Cost Benefit Analysis methodology has become the cornerstone of funding for the preponderance of projects co-financed by the European Commission and this has meant that the national Managing Authorities of the EU Member States have had to familiarise themselves with its methodology and apply it to real situations over the past decade. The EU’s Structural Funds, Cohesion Fund and Instrument for Pre-Accession, for instance, all require the undertaking of Cost Benefit Analysis when the project value exceeds a certain threshold that varies by instrument and by thematic area. This extent of utilisation has spurred the evolution of the methodology itself and has greatly increased the demands being made of Cost Benefit Analysis as a paradigm. Cost Benefit Analysis methodology has therefore become central to projects to be co-financed from the major EU Funds earmarked for development and has, on that showing, acquired a special status in the development arena of EU Member States and aspiring EU Member States in all the sectors which these funds are used for, including (but not limited to) transport, energy, health, waste, industry and the environment. Needless to say, Cost Benefit Analysis methodology has acquired, through the purposes to which it has been put to use, a very great influence on development, its sustainability, its inclusivity properties and the quality of life of the citizens of EU Member States and of those states that are aspiring to become EU Member States. With a view to obtain a certain level of harmonisation in the use of Cost Benefit Analysis methodology, as well as to help civil servants, consultants, reviewers in Member States, EU officers and others involved in the delicate and highly-contentious work of Cost Benefit Analyses, the EU’s Directorate General for Regional Policy (DG Regio) has commissioned the compilation of a comprehensive document to serve as Guidelines for the undertaking of CBAs.
The CBAs undertaken by Equinox usually encompass, as a minimum, the following sections:
- Context Analysis
- Project Objectives
- Project Identification
- Feasibility And Options Analysis
- Demand Analysis
- Available Technology
- Production Plan (Including the Utilisation Rate of the Infrastructure)
- Personnel Requirements
- The Project’s Scale, Location, Physical Inputs, Timing And Implementation, Phases Of Expansion And Financial Planning
- Environmental Aspects
- Identification Of Preferred Option
- Financial Analysis
- Investment Cost
- Operating Costs And Revenues
- Financial Return To Investment
- Sources Of Financing
- Financial Sustainability
- Financial Return To Capital
- Economic Analysis
- From Market To Accounting Prices
- Monetisation Of Non?Market Impacts
- Inclusion Of Additional Indirect Effects (Where Relevant)
- Social Discounting
- Calculation Of Economic Performance Indicators
- Analysis Of Funding Needs And Computation Of Funding Gap If Relevant
- Risk Assessment
- Sensitivity Analysis
- Probability Distribution Of Critical Variables
- Risk Analysis
- Assessment Of Acceptable Levels Of Risk
- Risk Prevention
Equinox has also developed its own in-house MS Excel add-ins to run sensitivity analyses on its models and to test the Cost Benefit Analysis paradigm under the assumption of different statistical distributions for its underlying variables.
Subject to the total estimated value of the project being in excess of EUR 5 million and the availability of a budget, it is sometimes recommendable to undertake discrete choice experiments such as Contingency Valuation surveys or multi-criteria analyses to be able to have a stronger basis on which to build the edifice of Cost Benefit Analysis. This usually results in an increased ability to defend the study’s results if challenged by a reviewer or evaluator.